Updated July 15, 2023
Definition of Accelerated Depreciation
Accelerated Depreciation is the type of Depreciation method on fixed assets in which the asset depreciates at a faster rate as compared to normal traditional methods of Depreciation, like the straight-line method or written-down method or in other words. It is the depreciation method in which the asset’s book value reduces at an accelerated rate, i.e., faster than the normal depreciation methods.
Explanation
There are various methods of Depreciation on fixed assets. However, in accelerated depreciation, the depreciation rate applied to assets is higher than that of the other depreciation methods. In accelerated depreciation, the book value of assets reduces faster than applying the other traditional depreciation methods.
Generally, the depreciation rate in the earlier years is higher, and in later years, the depreciation rate reduces compared to traditional methods. Hence the difference between the traditional and accelerated depreciation methods is the timing difference of depreciation.
Example of Accelerated Depreciation
Let’s assume the company ABC Ltd. ABC Ltd has purchased machinery worth $500,000.The useful life of the machinery is 10 years.ABC Ltd is calculating the depreciation using two methods.
Straight Line Method of Depreciation:
| Particular | Value |
| Purchase price of the Machinery | $500,000.00 |
| The useful life of the Machinery (years) | 10 |
Solution:
- Depreciation = $500,000/10
- Depreciation = $50,000
Depreciation per year is $50,000
Accelerated Method of Depreciation
| Particular | Value |
| Purchase price of the Machinery | $500,000.00 |
| The useful life of the Machinery (years) | 10 |
Solution:
- Double declining balance method
- Depreciation = ($5,00,000/10)*2
- Depreciation = $100,000
Depreciation per year is $100,000
- The sum of years digit method
Depreciation Formula = (Number of Useful Years Remaining / Sum of Useful Years) * Purchase Cost.
- Depreciation = ((10 / (10 + 9 + 8 + 7 + 6 + 5 + 4 + 3 + 2 + 1)) * $5,00,000
- Depreciation = $90,909
Depreciation per year is $90,909
The above example shows that the depreciation in the straight-line method is lower than the depreciation in the accelerated method of depreciation.
Methods of Accelerated Depreciation
Different methods are mentioned below:
- Double Declining balance method of depreciation: In this method of depreciation, the book value of the asset gets depreciates at the constant rate each year, which is generally double the rate of depreciation that applies in the straight-line method of depreciation, i.e., the rate of accelerates depreciation=2X the rate of depreciation in straight-line method
- The sum of years digit methods: In this depreciation method, the remaining useful years of the asset consider along with the asset’s total useful life.
- The formula for calculation of accelerated depreciation in this method = (number of useful years remaining/sum of useful years.)*Purchase cost
Accelerated Depreciation Deductions
- Due to the use of accelerated depreciation, the reported profit of the enterprises is lower in the earlier years, which increases in the later part of the year. Hence the tax liability of the enterprise in the earlier years is lower than the tax liability of the enterprise in the last years. Therefore, we get more tax deductions in earlier years.
- However, it must consider that the asset’s total tax liability does not change. It is only the timing difference of tax payment.
- However, let’s consider the time value of money. The enterprise benefits from an income tax reduction in the earlier year compared to an income tax deduction in a later year.
- In the case of accelerated depreciation, the asset fully depreciates on paper. However, in reality, the asset is still in existence. In this case, the income tax Department takes back the depreciation it has allowed earlier, which results in a loss to the enterprise.
Impact of Accelerated Depreciation
The following is the impact of Accelerated Depreciation
- It has a higher effect on manufacturing industries than other lines of business.
- Accelerated depreciation impacts the enterprise’s debt to asset ratio, profit margin ratio, and Return on asset ratio.
- The use of accelerated depreciation affects the tax planning of the enterprise. Per the above discussion, due to accelerated depreciation, the tax liability of the enterprise reduces in the present; however, it increases in the future. Because of this, the enterprise has to invest much time in the tax planning of the current year, taking into consideration the tax planning of the future years.
Benefits
Different benefits are mentioned below:
- Reduction in the reported net income of the enterprise: In the accelerated method of depreciation, the depreciation rate is higher in the initial years, thus increasing the depreciation expense. So this increases the total expense amount in the income statement, and the net income gets reduced due to this higher volume of expense.
- Reduction in tax liability: The enterprise utilizes the saving in the form of tax liability for future projects or expansion of the current business, as it reduces its tax liability due to the lower reported net income resulting from increased expenses on the income statement.
- Allowance of deferred tax: Many enterprises use the accelerated method of depreciation to create the provision for deferral tax liability in the books of accounts of the enterprise. Due to the high deduction of depreciation in the earlier years, the enterprise’s net income gets reduced in the earlier years and increases in the later years, which results in the creation of deferred tax, which the enterprise is liable to pay in the future. Hence, the provision for DTL, i.e., deferred tax liability, is created in the books of accounts by the enterprise.
Disadvantages
- Unclear picture of the financial statements: In this depreciation method, the higher expenses are reported in, the earlier years, which get reduced later. As shown in the statements, the assets are not worn out due to accelerated depreciation. Hence, the investors do not get a clear picture of the organization’s financial health, leading to confusion about when to invest in the enterprise, thus affecting decision-making.
- Higher payment of taxes in later years: In the accelerated method of depreciation, the enterprise has to pay low tax in the initial years due to low reported income; however, contrary to the above, the income of the enterprise increases in the later years because the depreciation expense in the later years gets reduced, and hence the tax liability of the enterprise in future also increase in future the enterprise falls under higher tax bracket, and this can create a problem to the enterprise in the planning of its financial projects.
- The wrong reported value of the asset: In this method of depreciation, the asset depreciates fully on paper, and hence the enterprise cancels the asset because the economic value of the asset gets zero due to the depreciation reported; however, in reality, the asset still has the value. The depreciation, which was earlier allowed by the income tax department, can be taken back, leading to the enterprise’s loss.
Conclusion
The use of accelerated depreciation by the enterprise does not give the true picture of the books of accounts of the enterprise, thus affecting the investors’ decision-making. Hence to invest in the enterprise, the investor should not only rely on the income statement or the use of the depreciation method by the enterprise. Like the cash flow statement, the other financial statements should also be studied before investing in the enterprise. Also, the investor should thoroughly study other information like present tax liability and the expected future tax liability of the enterprise due to the use of accelerated depreciation before investing in the enterprise.
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